Download cost of capital

The Cost of Capital
ID: ma3n0224
name: Suvdaa
Chapter 11- Concept
Cost of Capital is an extremely important financial concept.
 In this chapter we will demonstrate how to calculate the cost of
specific sources of capital and combine them to arrive at a weighted
average cost of capital that firms can use to evaluate investment
opportunities.
 A weighted average cost of capital (WACC) is a calculation of a firm's
cost of capital in which each category of capital is proportionately
weighted. All capital sources - common stock, preferred stock, bonds
and any other long-term debt - are included in a weighted average
cost of capital calculation. All else equal, the weighted average cost of
capital of a firm increases as the beta and rate of return on equity
increases, as an increase in weighted average cost of capital notes a
decrease in valuation and a higher risk.
Basic Concept
The cost of capital is the rate of return that a firm must earn
on the projects in which it invest to maintain the market value
of it’s stock. It can also be thought of as the rate of return
required by the market suppliers of capital to attract their
funds to the firm. It acts as a major link between the firm’s
long-term investment decisions and the wealth of the owners
as determined by investors in the market-place. It is, in effect,
the “magic number” that is used to decide whether a
proposed corporate investment will increase or decrease the
firm’s stock price.
The cost of capital is estimated at a given point in time. It
reflect the expected average future cost of funds over the
long run. Although firms typically raise money in lumps, the
cost of capital should reflect the interrelatedness of financing
activities. We need to look at the overall cost of capital rather
than the cost of the specific source of funds used to finance a
given expenditure.
key assumptions:
Business Risk
—the risk to the firm of being unable to cover
operating costs—is assumed to be unchanged. This
means that the acceptance of a given project does not
affect the firm’s ability to meet operating costs
Financial Risk
—the risk to the firm of being unable to cover required
financial obligations—is assumed to be unchanged.
This means that the projects are financed in such a
way that the firm’s ability to meet financing costs is
unchanged.
After-tax costs are considered relevant.
Cost of Capital formulas
In the wake of the terrorist attacks in
September of 2001
United Airlines
 Hence airlines saw costs rise and passenger volume decline.
 United Airlines Corporation- In 2002 sought protection from
creditors while attempting to reorganize. After 3 years of
complex restructuring, the airline finally emerged from
bankruptcy on 2006. The extensive restructuring measures- $7
billion in yearly cost reductions from renegotiated airplane
leases, new labor contract, 20,000 job cuts, and the elimination
of pension obligations-gave it the needed financial edge to fly
on its own again. As part of its restructuring, United Airlines
required a $3 bollion financing package, provided through a
sydnicate led by JPMorganChase and Citigroup Global
Markets. UAL received offers of subscription for more than
twice the capital necessary to support the $3 billion it sought.
As a results, it was able to reduce its financing costs by 75
basis points(0.75%). The financing consisted of a $2.8 billion
term loan and a $200 million revolving credit line.
In 2007, a year after emerging from bankruptcy, UAL was able to
restructure its $3 billion dept. Using cash, it paid down $972 million
of the original $3 billion loan and refinanced the remaining $2
billion. Once again, it eas able to lower its financing costs because
of oversubscription of the refinancing. The new loan was set at
200 basis points (2.00%) over LIBOR, a reduction of 175 basis
points (1.75%) from the original financing cost. The lower pricing is
expected to result in net pre-tax savings of approximately $70
million per year.
Although UAL was able to meet its capital needs primarily from
operating activities and the issuance of debt, other corporating rely
more heavily on issuance of common stock. Each method of
raising capital has its unique costs and benefits. Often companies
will strive to meet some desired mix of debt and equity capital
financing.
Conclusion
 So United Airlines must be assess the investment
opportunities. Its arrive cost of capital and weighted
average cost of capital associated with refinancing.
 United Airlines, It will able to lower its financing costs
because oversubscription of the refinancing.
 UAL need to calculate the cost of retained earnings and
the cost of new issue of common stock.
 In this chapter we will demonstrate how to calculate the
cost of specific sources of capital and combine them to
arrive at a weighted average cost of capital that firms can
use to evaluate investment opportunities.
Example: United Airlines
Thank you 